The model in this paper describes a principal-agent structure with investors as principals and brokers as agents, where the principals are subject to moral hazard by the agents. Investors and brokers are randomly matched and transact for a single period where cheating by the broker is possible. We show that cheating is more likely (and trust is therefore lower) when the social distance between agents is larger, formal institutions are weaker, social sanctions against cheating are ineffective, the amount invested is higher, and the investors' wages are lower. Most importantly, the model shows that the amount invested decreases as social heterogeneity increases, and when formal and informal institutions are weaker, adversely impacting income growth. These implications have strong support in our cross-country empirical work. Trust, and the social and institutional factors that affect it, significantly influence growth rates. Thus, this research provides a new insight into the way that social and institutional factors impact economic performance.
The model in this paper generalises to other principal-agent relationships, for example, creditors and debtors, employers and employees, clients and consultants, insurers and insured, and retailers and consumers. Further, our conceptual definition of trust, and our empirical measures, encompass prisoners' dilemmas as well as principal-agent incentive structures.
Several extensions of the model here would be interesting to undertake. First, the random matching of transacting agents could be relaxed by allowing the probability of a match between two agents to vary inversely with the social distance between the two, as in Akerlof (1997). In this case segregation increases, and time devoted to investigating brokers falls. A second extension along this line is to permit agents to choose whether or not to trade with each other using a matching technology as in Burdett and Coles (1997). Again, this would lead to economic segregation. With sufficiently extreme segregation, time spent investigating approaches zero, and trust ± the proportion of time spent working ± approaches one. There are potentially enormous costs associated with extreme segregation, however, as gains from specialisation may be severely limited, particularly where there are many agent groups, or where a scarce resource is concentrated within one agent group (e.g., Lebanese entrepreneurs in Africa, or Jewish bankers in medieval Europe).
Taking into account the value of leisure, and of transactions facilitated by trust that do not enter the national accounts, the model also predicts that trust should be positively related to subjective measures of well-being across countries or other economic units. J. S. Mill (1848, p. 131) argued that `The advantage to mankind of being able to trust one another, penetrates into every crevice and cranny of human life: the economical is perhaps the smallest part of it, yet even this is incalculable.' We thus would expect that more inclusive measures of well-being will be associated with trust in the same way that, as we have shown here, investment and growth improve with trust.